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The European Central Bank (ECB) might allow certain banks to collapse as the era of unprecedented monetary stimulus is ending, putting bailouts for undercapitalised banks burdened with ‘bad loans’ into question.

Several Italian banks, most prominently, the world’s oldest institutionalised lender Banca Monte Paschi, have been struggling amidst low capitalisation and the excessive amount of non-performing loans (NPLs) for several months. The Italian government is seeking ways to bailout such banks, but the ECB, pursuing a tougher monetary policy, seems reluctant to help.

"In specific cases consolidation may also take the form of the unwinding of banks if they become unviable," Danielle Nouy, head of the ECB supervisory body, told the European Parliament on Thursday.

The North-South divide between the Eurozone member states over the monetary policy has been straining the internal relations within the bloc. The Frankfurt-based ECB is favouring a tougher approach to policies and is aiming to end the unconventional monetary stimulus that combines near-zero and negative interest rates with a bond-buying programme in order to provide commercial banks with an increased amount of affordable capital. The heavily-indebted nations of the European South would like to extend such policies as they are favouring a looser monetary environment.

The ECB is now intending to look into the books of the two Italian banks, Banca Popolare di Vicenza and Veneto Banca to determine whether they have enough capital to offset the risks posed by the abundance of NPLs on their accounts. The next step would be an approval or rejection of Italy’s bailout bid.

The ECB’s Nouy said that a bailout would limit the regulator’s ability to address other risks and would also diminish the ECB’s overall efficiency managing the Eurozone’s banking system.

"Most prominently, the proposal may frame supervisory action too tightly," Nouy said. "It does so by constraining the flexibility required by the supervisor in taking action in cases not foreseen in the legislation and in determining the composition of the Pillar 2 capital requirements."

Pillar 2 is the name for capital requirements set by the ECB, but reserve requirements also tend to vary slightly between the Eurozone member states. Nouy’s point is that reserve requirements should be homogenous and fall in line with the ECB rules and global rules so that the central bank could more efficiently assess the risks of possible bailouts.

Therefore, some banks, in particular, in Italy, might not receive the bailout capital they are hoping for. The ECB is also currently ending its four-year programme that provided free cash to commercial banks within a broader pivot to tightening its policies.

“The banking sector’s capacity to fully support the euro area’s recovery is curtailed by its low profitability,” ECB President Mario Draghi said on Thursday. “Overcapacities, inefficiencies and legacy assets contribute to banks’ low profitability. It is up to the banks themselves to find appropriate answers to these challenges. And for the sake of a strong recovery in the euro area, they must do so quickly.”

Thus far, the Targeted Longer-Term Refinancing Operations (TLTRO) programme has provided commercial banks with some 570 bln euros since it was enacted in 2014. Commercial banks borrowed this money free of interest to lend out to their customers at a commercial interest rate, thus making some profit off the programme. However, TLTRO seems to have done little to boost the resiliency of the European banking system.

Overall, the ECB’s negative interest rates policy (NIRP) and the 2.28-trln-euro bond-buying programme, all introduced as a response to the 2011 debt crisis, have had only limited effects, supporting most banks in their struggle to stay afloat. The quality of bank assets and lending practices have remained largely unaddressed, which resulted in the current NPL and undercapitalisation crisis, most prominent in Italy.

Nouy’s message of ‘too many banks’ in the Eurozone suggests that the ECB has acknowledged the limited efficiency of its stimulus measures. In order to improve the quality of the euro area’s banking system, shutdowns might have been determined as necessary on the supervision level, yet, the ECB has yet to announce its plan to exit the unconventional stimulus, and outline the bank bailout or non-bailout criteria.

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